October 13, 2019
We characterize time-varying disaster risk using interbank rates and their options. The identification of disaster risk has remained a significant challenge due to the rarity of macroeconomic disasters. We make an identification assumption that macroeconomic disasters coincide with banking disasters – extremely unlikely events in which the interbank market fails and investors suffer significant losses. Based on our flexible reduced-form setup, interbank rates together with their options allow us to extract the short-run and long-run components of disaster risk.